What is ESG investing? ESG (which stands for environmental, social, and governance) could be seen as more of a risk management framework for evaluating companies, rather than a single, core investment strategy.
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ESG factors are part of an assessment process that is used to apply non-financial factors to an investor’s analysis in identifying material risks and growth opportunities. ESG measures the sustainability and societal impact of an investment in a company, and ESG criteria help to better determine the future financial performance of the company.
© Elnur / Shutterstock.comThe main drivers of ESG investing
ESG investing has undoubtedly become one of the hottest topics in investment management in recent years. As the world is changing, there is a greater requirement to understand what risks or opportunities a company faces from ESG issues. The key aspects that drive ESG factors are as follows:
- Environmental criteria: Currently, climate change — and the move toward net-zero greenhouse gas (GHG) emissions by 2050 — dominates the agenda, but this includes a company’s use of energy, waste, pollution, and natural resource conservation.
- Social criteria: These criteria comprise how a company manages relationships with its stakeholders, including employees, suppliers, customers, and the communities it operates in. The COVID-19 pandemic has emphasized the interconnection between sustainability and the financial system.
- Governance criteria: These criteria incorporate how a company’s leadership operates in relation to policies on audits, diversity, executive pay, illegal practices, inclusion, internal controls, and shareholder rights, and their willingness to engage in the sustainability reporting process.
Essential ESG definitions
There is no universal approach to measuring and reporting ESG performance. A company’s overall ESG rating is usually calculated by summing the weighted score of each unmanaged ESG risk factor. Therefore, it helps to know a few key definitions to understand the main elements within ESG investing. In addition, there are a few definitions that define issues generated by ESG investing:
- ESG rating: This is calculated based on a company’s material exposure to company-specific and general-industry ESG risk, and how they manage those risks. The ESG rating can be calculated by summing the weighted score of all E, S, and G ratings or by focusing on individual ratings.
- Material indicators: Financially material ESG factors have a significant impact — both positive and negative — on a company’s business model and value drivers. They differ from one industry sector to another, but emphasize topics that affect a company most.
- ESG integration: This is the incorporation of all material ESG factors in investment analysis and decisions to determine the potential impact on company and sector performance.
- Exclusions: The use of exclusions is a traditional approach to considering ESG factors, by excluding unacceptable stocks from a portfolio, based on their ethical or environmental practices.
- Greenwashing: This occurs when ESG investment products are sold as a solution to address a sustainable issue when the subsequent sustainable components’ results are questionable.
- Stewardship: If governance is considered to be the rule book (the way norms and actions are structured, regulated, and held accountable), then stewardship is the playbook (the responsible allocation, management, and oversight of capital, leading to sustainable benefits for the economy, the environment, and society).
- Stranded assets: These are assets that, at some point prior to the end of their economic life (for example, a coal mine), become worth less than anticipated due to the transition to a low-carbon economy (creating lower-than-expected demand or prices).
ESG themes that are growing in importance
When considering ESG approaches, it’s important to recognize which underlying themes are producing some of the key risk factors within ESG investing. The following list highlights the more material ESG issues:
- Climate change: Investors care about climate change and are looking for greater disclosure on how it will affect companies. They will be closely watching renewable energy trends and the fate of stranded assets.
- Biodiversity: Long-term biodiversity loss is becoming recognized as critical to the environmental agenda, and it may have serious impacts on both people and the economy as biodiversity loss and climate change are accelerating the scale of the planetary crisis we face.
- Social inequalities: The COVID-19 pandemic has brought social factors further into the spotlight. The pandemic has intensified social and gender inequalities, and there will be added pressure on companies to take greater accountability of the welfare of their workforce, the community at large, and individuals in their complex supply chains.
- Supply chain management: The need for greater transparency in global supply chains was exacerbated by the COVID-19 pandemic. Companies will need to provide greater visibility into their operations related to labor practices, health and safety, and human rights.
- Digital ethics and inclusion: The use of digital channels is increasing, and so two major themes are in focus. Digital ethics refers to data privacy, cybersecurity, online welfare, ethical design of artificial intelligence, and related issues. Digital inclusion refers to the access, skills, and benefits connected to digital technologies.
- Corporate issuers: Corporations are watching developments in the green and sustainable bond space as volumes and liquidity continue to grow. ESG isn’t just a stock-based investment, and fixed income will grow in importance, with ESG ratings intermingling with credit ratings.
- Standardization: There are a range of different sustainability reporting frameworks and standards. Standard-setters, such as the Global Reporting Initiative (GRI) and the Sustainability Accounting Standards Board (SASB), are driving better alignment of sustainability reporting frameworks. Further regulation is likely to lead to mandatory, rather than voluntary, reporting requirements.
- ESG goes mainstream: The ESG market is reaching further maturity as the ESG investing boom continues. What was once considered to be a niche investment area is quickly becoming mainstream as environmental, social, and governance considerations continue to develop.
- New investment benchmarks: If investors are truly following a sustainable mandate, then they should expect to see tracking error deviations from established benchmarks. There is a question as to whether this will lead to a reevaluation of typical benchmarks and an increase in demand for customized benchmarks.
